Windfall taxWindfall tax

Ten years ago, the range of tax-efficient options open to private investors in venture capital was very narrow. Many of the Business Expansion Scheme investments promoted in the 1980s failed to perform and activity became concentrated on the asset-backed 'assured tenancy' vehicles.

Not before time, the Treasury began consultations to see if a way could be found to encourage private investors to channel their money, with the benefit of tax relief, into small private growth companies in the UK. The result ' venture capital trusts (VCTs).

VCTs were formally established by the then Chancellor Kenneth Clarke in the 1995 Finance Act. The boundaries were carefully drawn to facilitate success: VCTs have to be listed on the London Stock Exchange and managers have to demonstrate a track record of experience in managing the type of unlisted investments in which VCTs specialise.

To avoid the manic BES rush to invest funds by 5 April each year, VCTs have three years to invest the required 70% of their funds in suitable unlisted companies. Finally, the £1m limit on individual investments ensures a reasonable spread of holdings within a VCT's portfolio.

Over the past six years, the VCT movement has become well established as an investment sector in its own right. There are now over 50 VCTs, with a cumulative total of over £1bn raised from investors, and the availability of tax reliefs has been central to this success.

If there is such a thing as a 'typical' VCT investor, then he or she is relatively well-off, middle-aged, understands the business world, is comfortable with a degree of investment risk and is in a position to utilise capital gains tax shelters as well as income tax relief.

For such an individual, the combination of tax incentives and the investment potential of venture capital is very attractive.

The specific tax incentives on offer for VCT investors include:

l Income tax relief at 20% on subscriptions for new VCT shares (provided the shares are held for at least three years).

l Deferral of capital gains tax where a chargeable gain is re-invested in new VCT shares (the gain being deferred for as long as the VCT shares are held).

l Income tax exemption on dividends paid by VCTs (unlike other investment trusts, VCTs can actually pay out realised capital gains by way of dividend).

l Exemption from capital gains tax on the disposal of shares in a VCT.

These reliefs apply to investments of up to £100,000 in each tax year.

Recover 60% cash cost

The combination of income tax relief and CGT deferral means that a higher-rate taxpayer can in effect recover 60% of the cash cost of investing in a VCT. Although the traditional pre-5 April rush is still a familiar feature, VCTs are increasingly seen as a year-round tax planning opportunity. For the investor with capital gains to shelter, the key point is that the gain can fall anywhere within 12 months before or after the VCT investment is made. For example, a capital gain realised on 30 September 2001 could be set against a VCT investment any time between 1 October 2000 and 29 September 2002.

Here are six key action points for advisors to put to potential VCT investors:

l Make sure you have your financial priorities sorted out. VCTs are an excellent tax planning tool, but do not neglect the financial basics such as life insurance, pension provision, Isas, and so on.

l Decide where VCTs fit in your overall investment strategy. Most investors will benefit from having a well-spread portfolio of holdings, and VCTs (particularly those with a generalist investment policy) can help achieve this. There are also a number of VCTs that have a more focused approach, specialising in sectors such as information technology, media, healthcare and the AIM market.

l Do your research. Every VCT will publish a detailed prospectus setting out its offering, and careful reading is essential. You can also monitor the coverage of VCT issues in the specialist financial press and in the personal finance sections of the Saturday and Sunday newspapers. If you have access to the internet, a large amount of high-quality analysis is available on-line: check out the websites of Bestinvest (www.bestvct.co.uk) and Allenbridge (www.tax-shelter-report.co.uk) for independent commentary on VCTs' past performance and for reviews of issues currently open.

l Be pragmatic. VCT issues from the leading managers are likely to be popular with investors, so do not leave the investment decision until the last minute. In the 2000/2001 tax year, several issues from little-known managers were withdrawn late in the day due to lack of support, leaving investors scrambling to find another home for their money ' one issue was pulled on the last day of the tax year. There is a good range of management firms that have the right combination of track record, battle-hardened investment staff and a strong flow of potential deals.

l Do not let the tax planning tail wag the investment dog. The tax breaks associated with VCTs are undoubtedly very attractive but always satisfy yourself that the underlying investment case makes sense.

l Be patient. Most VCTs will not achieve spectacular overnight success, and those that do will not necessarily sustain it in the long run. Venture capital investment is for the medium to long term, and from a standing start it is likely to be several years before a new VCTs investments begin to bear fruit. But the statistics show that over the past ten years the venture capital sector has generally out-performed the markets.

None of these action points will come as a surprise to the experienced advisor. VCTs are good news to the tax planner, and a methodical approach should literally pay dividends for many years to come.

key points

VCTs have three years to invest required 70% in suitable unlisted companies.

VCTs are increasingly seen as a year-round tax opportunity.

VCT tax incentive on offer is 20% income tax relief on subscriptions for new VC shares.

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